L e ss Re a lly Ca n b e Mo re : Why Simplic ity & Co mpa ra b ility Sho uld b e Re g ula to ry Ob je c tive s Richard J. Herring herring@wharton.upenn.edu Wharton School Panel on Post-Crisis Financial Reform in the US and Europe 80 th Meeting of the International Atlantic Economic Society Boston, MA October 10, 2015 1
Ove rvie w Why complexity is a threat to financial stability How complexity contributed to the crisis — Complexity in financial instruments — Complexity in financial regulation — Complexity in financial institutions — Complexity in bankruptcy resolution procedures Regulatory reform has generally exacerbated complexity Why simplification is so difficult 2
Ho w c o mple xity c o ntrib ute d to the c risis Co mple xity in F ina nc ia l I nstrume nts 3
E xa mple : CDOs An innovation that averted prudential oversight and obscured the transfer of risk Financial institutions sold assets to off-balance sheet entities, SIVs, that funded purchases by selling claims to the cash flows. Mitigated risk thru — Diversification — Overcollateralization — Subordination of tranches — Private insurance Each mortgage-backed CDO might contain ca. 750k mortgages* — Accompanying might run 30k pages *Haldane, 2009 4
I nc re a se d vulne ra b ility o f syste m to c risis Inflated volume of debt based on same underlying collateral — Implicit leverage defied market or supervisory scrutiny Many of securities were short-term commercial paper — Liquidity risk addressed with 364-day lines of credit from banks — Maturity limit averted capital requirement for standby line of credit 365 days and over When value of CDOs questioned, markets seized up because of difficulty in linking to value of the underlying collateral 5
Ho w c o mple xity c o ntrib ute d to the c risis Co mple xity in Re g ula tio ns 6
T he E xa mple o f Re g ula to ry Ca pita l Under Basel I, calculation of regulatory capital relatively simple — 4* categories of risk assets — 2 kinds of capital — 2 ratios, easily computed on postcard — Facilitated comparisons of capital strength In quest to make capital regulation more risk sensitive, Basel II added considerable complexity — Risk buckets expanded to over 200,000** — Computation of regulatory capital requirement entails over 200 million calculations** — Defies effective monitoring by supervisors or market — Impedes comparison across banks or for the same bank over time *5 categories in some countries 7 **Haldane (2011)
Co mple xity o f De finitio n o f Re g ula to ry Ca pita l I nvite d L o b b ying a nd I nno va tio ns to Re duc e Burde n Basel I defined two kinds of regulatory capital: Tier 1 and Tier 2 — Tier 1 capital required to be 4% of RWA, mainly equity Over time Basel Committee took into account innovative capital instruments designed to reduce burden – e.g. TRPS — Equity proportion of Tier 1 fell to 2% Implicitly authorized huge expansion in leverage — RWAs usually can 50% of RWA — Thus permissible leverage increased to 50:1 — Treated as obscure technical issue • No public debate • Apparently no realization among regulators about impact on risk 8
T ie r 1 was De g rade d b y I nno vatio ns in Hyb rid Capital
T ie r 1 RWA Ra tio F a ile d to Wa rn o f Crisis Pro ve d Pe rve rse I ndic a to r o f Re la tive Stre ng th Citi Tier 1 ratio peaked at 11.8% when market cap was roughly 1% of account value of assets Source: Capital IQ & Bank or England Calculations. Haldane, Andrew, 2011, “Capital Discipline,” January 9, Chart 5.
Pro b le ms Arising fro m Co mple xity o f Re g ula tio ns Opaque — Difficult to verify compliance or exercise effective supervision — Impede effective market surveillance and discipline Facilitates lobbying and innovations to undermine regulatory constraints — Highly technical regulations largely escape public scrutiny that might otherwise serve as a counterforce — Increases danger of regulatory capture Increases costs of implementation, monitoring and compliance — Growth in regulatory workforce and in compliance functions in industry should raise questions about opportunity costs — Prior to 2008 very difficult to argue that resources enhanced safety and soundness “Regulatory capital ratios may have become too complex to verify, too error-prone to be reliably robust and too leaden-footed to enable prompt corrective action”* *Haldane’s (2011) summary of possible criticisms 11
Ho w c o mple xity c o ntrib ute d to the c risis Co mple xity in Re g ula to ry Struc ture 12
T he Re g ula to ry We b Pre Do dd- F ra nk Partly De c o nstruc te d Source: Financial Times 13
Pro b le ms Arising fro m Co mple xity o f Re g ula to ry Struc ture System “Rife with duplication, gaping holes, and counter-productive competition among regulators.”* — For international banks redundancy and loopholes multiply exponentially Despite emphasis on functional regulation, fragmentation of oversight within functions — Financial innovation has trumped statutory definitions of functions • Essentially the same product can be regulated very differently depending on structure firm has selected — Even holding company oversight tends to focus on a particular function — No regulatory authority had overview of risk exposures of large institutions, much less the interplay of risk among them *Paulson (2013) 14
Crisis e xpo se d fa ilure s in struc ture o f re g ula tio n Despite responsibility and power to oversee: — Banks , FED found it necessary to bailout 3 of 5 largest BHCs — Investment banks , SEC failed to prevent big five investment banks from taking excessive insolvency risks that led to their demise — Thrift holding companies , OTS failed to prevent AIG and Washington Mutual from taking on ruinous risks Ability to shift regulatory jurisdictions or to avoid regulation altogether increased vulnerability to crisis and impeded crisis management and resolution 15
Ho w c o mple xity c o ntrib ute d to the c risis Co mple xity in I nstitutio na l Struc ture s 16
G-SI Bs Ha ve Gro wn in Ge o g ra phic Sc o pe , L e g a l Co mple xity a nd Ra ng e o f Ac tivitie s Management structure misaligned with legal structure — But legal structure cannot be ignored in event of financial distress Cross-border complexity implies at least two countries must be involved in resolution — Laws, processes and procedures vary substantially across countries — Most G-SIBs have legal entities in scores of countries Cross-sectoral complexity implies at least two functional regulators must be involved in resolution 17
Cro ss-Bo rde r Co mple xity T he b ro ad sample o f G-SI Bs G-SIBs have considerable international scope Assets % foreign Total Number of % foreign % subs in assets subsidiaries countries subsidiaries off-shore centers Average $1.587 42% 1,002 44 60% 12% trillion Range $3.100 87% 2,460 95 95% 28% high trillion low $0.243 5% 56 14 7% 3% trillion Assets and total subsidiaries as of yearend 2013; number of countries, % of foreign subsidiaries and % of subsidiaries in offshore financial centers as of May 2013; % of foreign assets as of 18 yearend 2012. Source: Computations from Bankscope data and banks’ annual reports.
Pro b le ms Oversight fragmented across several nations and often several functional regulators within nations Institutional structure opaque to creditors and outside shareholders — Inhibited market discipline Institutions global in life, but national in death — Insuperable difficulties in coordinating legal proceedings in multiple jurisdiction — Information so fragmented that impossible to preserve going concern value the group may have had — Provided rationale for bailouts as the only way to save the system 19
Ho w did re g ula to ry re fo rm a ddre ss the pro b le m o f c o mple xity? By intro duc ing still mo re c o mplic atio ns 20
Ac c e le ra tio n o f Ne w L e g isla tio n & Rule ma king Elaborate financial reforms in virtually every major country — Most will affect G-SIBs Dodd-Frank reforms (2010) still being implemented — 848 pages vs. 37 pages for Glass-Steagall (1933)) — Tens of thousands of pages of rulemaking and guidance A virtual blizzard of new legislation and rulemaking since 2010 21
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Wha t’ s ha ppe ne d to the c o mple xity o f re g ula to ry struc ture ? 23
Rube Goldberg might have designed the outcome
E limina te d OT S, b ut I ntro duc e d Ne w Ag e nc ie s a nd E xpa nde d Po we rs o f Othe rs 25 Source: JPMC Annual Report
Wha t’ s ha ppe ne d with re g a rd to c a pita l re g ula tio n? 26
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